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US stocks: Are you feeling lucky?

The world’s biggest ever initial public offering (IPO) of company stock has just taken place in the USA. Alibaba (NYSE:BABA), a Chinese e-commerce business founded in 1999, sold shares worth $25 billion. Owners of private companies are much more likely to sell out when they can get high prices for their stake. The Alibaba IPO is a reminder that US stock markets are trading at expensive levels.

The S&P 500 index of US stocks closed above the 2,000 level for the first time on 26th August. Since then it’s been fluctuating around that level, sometimes slightly above, sometimes slightly below.

There’s nothing special about reaching 2,000. It’s just a round number. But when prices pass above round number levels for the first time they tend to generate a lot of headlines and comment. “Stocks are going up!”, say the talking heads on TV. “All is well!”

But is it? I have my doubts.

As I write Alibaba has a total market capitalisation of $223 billion. That’s the value of the company at the current share price if 100% of it was listed on the stock market. It’s growing fast and 80% of China’s online sales go through it. Plus, unlike many hot technology companies, it actually has profits. However it still trades at 111 times last year’s earnings, which is a rich level by any sane benchmark.

But what of the US stock market as a whole? I wrote about how sceptical I was about US stocks in August last year. That was when the S&P 500 index first reached a new all time nominal high.

Since then the S&P 500 index is up from 1,710 to 1,994, which is a price rise of nearly 17%. Although, adjusted for inflation, the market is still below it’s all time peak set back in August 2000 of 2,045.

So was I wrong about US stocks? In one sense yes. I didn’t predict that prices would rise from already elevated levels to even higher ones. But then I think predicting short term price moves is a mug’s game.

“We admit honestly that we can’t predict where prices are going in the future, especially over the next year or two. In fact we don’t think anyone can reliably make short term price predictions.”

Here at OfWealth we believe in doing something else. We admit honestly that we can’t predict where prices are going in the future, especially over the next year or two. In fact we don’t think anyone can reliably make short term price predictions. Some soothsayers may have a run of luck for a while. But all of them will be wrong eventually, and burnt at the stake for their troubles.

So, instead of reading tea leaves or examining animal entrails with the aim of predicting the future, we concentrate on what we know today. Or at least what we think we know today.

Specifically we concentrate on market price levels relative to conservative estimates of underlying value. This approach is called value investing. It’s about buying stocks when values are above current market prices, and building in what’s known as a “margin of safety”.

We don’t know when the price of value investments will rise. But we think that buying things when they are already cheap is more likely to result in healthy profits than buying things that are already expensive and hoping for the best.

“Value investors can analyse a company’s financial statements, products, strategy and management quality and come up with a range of estimates for fair value.”

That’s fine at the individual company share level. Value investors can analyse a company’s financial statements, products, strategy and management quality and come up with a range of estimates for fair value.

If those estimates are made using conservative assumptions, and if the values are still well above market price of the shares, then chances are there is an investment opportunity. It won’t work out every single time, but it will work out well on average. Applied consistently and patiently the profits will roll in.

But at the level of a whole stock market index the process is slightly different. For example we can’t analyse all 500 companies in the S&P 500 index. It would simply take too much time. But one thing we can do is turn to history. History never repeats itself exactly. But in financial markets, by looking at past situations, we can get a sense of where things stand today.

Specifically there’s a wealth of data, especially in the USA, on historical valuation multiples. In general, if stocks are trading well below historical averages then they are good value, and if they’re trading well above average then caution is advised.

There are many different ways to look at this. But today I’ll concentrate on something known as the “P/E10”, also known as the “cyclically adjusted P/E” (CAPE) or “Shiller P/E”.

(It was popularised by Yale University professor Robert Shiller, who won a Nobel prize in economics in 2013. But just because it’s the favourite measure of a Nobel prize winning economist doesn’t necessarily mean it’s a bad idea.)

The P/E10 is similar to a normal price-to-earnings (P/E) ratio. As you already know, the P/E divides the price of a share by the earnings-per-share (EPS). So a share with a price of $24 and EPS of $1.50 would have a P/E ratio of 16 times earnings (often written “16x”).

A normal P/E is fine under normal circumstances. The higher it is then the higher the price is in relation to each dollar (or other currency) of company profits, and vice versa. But sometimes earnings collapse temporarily, causing the P/E to increase dramatically at the same time as share prices collapse as well.

For example the P/E ratio of the S&P 500 index shot up to a record level of 124 in May 2009 as banks reported huge losses during the global financial crisis, and other companies’ earnings suffered as well. This was despite the fact that the price level of the index had also crashed. So the P/E based on just the last year’s earnings can be misleading at times.

The P/E10 is an attempt to get around this and give a more reliable indicator. It looks at earnings over the past 10 years, adjusts each year for price inflation up to the present day, and then takes an average of the 10 inflation-adjusted figures.

“That way you get a more reliable view of how much a buyer must pay to own the future stream of company earnings.”

The idea is to smooth out the short term swings in past earnings. That way you get a more reliable view of how much a buyer must pay to own the future stream of company earnings.

So where are we today in the US stock market? The chart below, which I found at dshort.com, does an excellent job of summarising the current position.

This looks at the P/E10 each month since 1881, with 1,603 data points in all. These then appear on the graph from the lowest result on the left hand side to the highest result on the right hand side. The horizontal axis shows the percentile where each data point appears.

So the results for P/E10 are evenly spaced from left to right, with the lowest result on the far left rising to the highest result on the far right. The middle point from left to right, or the median, is shown at the 50th percentile (50%). At this point, half the P/E10 results are higher and half are lower.

PE Ratio 10 Percentile

First you can see that the median (50th percentile) level gives an “average” P/E10 of 16.6. In the past the market has traded as low as 5 and as high as almost 45 (the latter during the height of the technology bubble which peaked in year 2000). At the end of August this year the figure was 25.6.

Including the technology bubble, at the end of August the S&P 500 P/E10 ratio was at a level above 92% of the historical results. This compares with 95% at the 2007 peak (P/E10 around 28), just before the global financial crisis, and 97% in 1929 (P/E10 around 33), just before the famous Wall Street Crash.

“It may not be in a full blown bubble such as in 1929 or 2000, but it’s definitely near the top end. And it’s 54% above average.”

In other words, using the P/E10 ratio the market looks very expensive. It may not be in a full blown bubble such as in 1929 or 2000, but it’s definitely near the top end. And it’s 54% above average.

Put another way, for the S&P 500 index to return to an average valuation would mean a price fall of 35% down to around the 1,300 level. That said, I have no idea whether that is going to happen soon, or even in the next few years.

But I’m confident of one thing: investors in the S&P 500 index of US stocks, at today’s elevated levels, are highly unlikely to make attractive profits in coming years. And they may make substantial losses. Even without a crash the P/E 10 is likely to revert to the average over time. That means earnings will have to grow faster than normal to make up for the fall in multiple.

One more thing. Although we can never predict the timing of the crash we know from history that these things come around fairly regularly. In the USA the average time between significant stock market downturns has been 5.25 years since 1871.

The last peak was in October 2007, just under seven years ago. The previous peak was in early 2000, just over seven years previously. This bull market is already living on borrowed time.

Are you feeling lucky? Because you’ll need to be to make a decent profit from US stocks in the coming years.

My recommendation: look elsewhere.

Stay tuned OfWealthers,

Rob Marstrand
robmarstrand@ofwealth.com

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Rob is the founder of OfWealth, a service that aims to explain to private investors, in simple terms, how to maximise their investment success in world markets. Before that he spent 15 years working for investment bank UBS, the world’s largest wealth manager and stock trader with headquarters in Switzerland. During that time he was based in London, Zurich and Hong Kong and worked in many countries, especially throughout Asia. After that he was Chief Investment Strategist for the Bonner & Partners Family Office for four years, a project set up by Agora founder Bill Bonner that focuses on successful inter-generational wealth transfer and long term investment. Rob has lived in Buenos Aires, Argentina for the past eight years, which is the perfect place to learn about financial crises.